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Foreword - George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue 
The Theory of Free Banking: Money Supply under Competitive Note Issue (Lanham, MD.: Rowman & Littlefield, 1988).
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This book is an important work in monetary theory. As such it brings to mind a statement by the learned John Hicks in an essay that I always assign to my graduate students in Monetary Theory: “Monetary theory is less abstract than most economic theory; it cannot avoid a relation to reality, which in other economic theory is sometimes missing. It belongs to monetary history, in a way that economic theory does not always belong to economic history.” This is so, Hicks continues, for two reasons. First, the best work in monetary theory is often topical, aimed at understanding a monetary problem of the times. Second, monetary institutions are continually evolving, and with them the appropriate theoretical apparatus.*
The present work bears out Hicks’s generalization both by being topical and by being attuned to institutional evolution. It is topical because the outstanding monetary problem of our time is the failure of central banking to deliver the macroeconomic stability its adherents have promised. The Federal Reserve System, in particular, has not carried its own weight. This book offers a promising alternative. It is attuned to the evolutionary institutional developments not only of the recent past—the increasing competitiveness and partial deregulation of banking and financial markets—but also of the foreseeable future. A system of free banking of the sort analyzed here is plausibly the logical culmination of movements in the direction of monetary laissez-faire.
Not long ago the debate over government’s role in the monetary system was largely confined to conflicting sets of advice to the monetary authorities concerning their day-by-day activities. A few voices raised the broader issue of constitutional rules to restrain the monetary authorities. Happily, the professional and even political discussion of monetary policy options has broadened in recent years to include possibilities for doing without monetary authorities. The question now on the table is which ideal is more feasible: the ideal of a monetary bureaucracy that is mechanically apolitical and selflessly efficiency-minded, or the ideal of a purely private and market-disciplined monetary system.
Historical evidence on past monetary systems free of central banking is naturally important to this discussion. The first chapter of this book contributes a useful summary of such evidence. But empirical evidence must be interpreted in the light of theory. It is to the theoretical understanding of free banking that this work primarily and excellently contributes. The need for clarification and development of the theory of free banking is plainly acute. Free banking has gotten undeserved short shrift even from open-minded economists keenly interested in alternative monetary regimes because, to quote Robert J. Barro as a case in point, “the workings of a private, noncommodity monetary system are not well understood (at least by me).”*
The standard money-supply model of undergraduate textbooks assumes a central bank monopoly of currency and binding reserve requirements against demand deposits. Selgin reconstructs and extends the theory of money supply under free banking conditions, that is, where competing private banks are legally unrestricted in creating currency and demand deposits (and are compelled by market forces to make their liabilities redeemable for an outside money). There has been surprisingly little work on this topic, despite the recent growth of professional interest in alternative monetary systems. Happily my own modest theoretical effort† is now succeeded by Selgin’s several longer steps in the direction of a modern theory of free banking.
The theoretical excellence of this study lies not in developing high-powered mathematical techniques, but in deriving surprising results from the thoughtful and novel application of familiar money-and-banking ideas. The central results show that the standard “rule of excess reserves”—that a competitive bank cannot safely expand its liabilities by more than the size of its excess reserves—applies to note-issuing as well as to the more familiar deposit-creating banks, provided that money-holders do not accept various brands of notes indiscriminately. The rule does not, however, apply to a monopoly issuer.
What is more provocative, we learn that the limits to note issue expand when the demand to hold inside money increases, and that the consequent expansion of bank liabilities and assets is warranted by considerations of credit-market equilibrium. A bank is able to vary its liabilities in response to demand shifts even if its reserves are unchanging, because an increase in holding demand implies a fall in the rate of turnover, hence in the optimal reserve ratio. The theory of optimal reserves elaborated by Selgin undermines the mechanistic textbook view of the reserve ratio as constant, and links changes in desired bank reserve ratios to changes in the money multiplier. A further surprising and novel extension is the refutation of the standard view that no economic forces check a concerted expansion by banks.
Later chapters usefully compare the problems facing free banking and central banking systems. A central bank that wants to behave neutrally is shown to lack the market feedback mechanism that informs competitive banks in supplying money. A equilibrium mix of deposits and currency in particular is more difficult to maintain under central banking. Various disfunctions that have been ascribed to a free banking system are either not compelling or are more severe under central banking.
The final chapter offers a proposal for monetary reform based on Selgin’s conclusions regarding the stability and efficiency of free banking. The case is compelling, and there is no need for me to argue its merits here. But I might note optimistically that the Selgin proposal holds out the hope of uniting the advocates of various programs (who are sometimes prone to overemphasize their variety) for the denationalization of money, a laissez-faire approach to monetary stability, the abolition of legal restrictions against private money, free banking, and (as the strictest of monetarist rules) the freezing of the monetary base.*
Given my personal involvement with this work, as the advisor of the New York University doctoral dissertation on which it is based, some comments of a more personal nature will perhaps be excused. In an interview recorded in Arjo Klamer’s Conversations with Economists, the macroeconomist Thomas J. Sargent observes that the most rewarding experience he has had as an economist is to see his students surpass what he has done: “A guy you remember, who first came to class and didn’t know anything, is now inventing new stuff that you have a hard time understanding, arguments that in general you couldn’t have thought of. What’s also nice is that some of them got the message, they are building on our shoulders.”* I would say that Sargent’s statement captures very well the way I feel about the present work by George Selgin, whom I am certainly proud to claim as a former student.
The statement fails to fit in a few ways, however. To begin with, I never actually instructed Selgin in a classroom. More important, he did know something when he “first came to class.” In fact, he arrived at NYU in fall 1981 already knowing that the topic of his dissertation was to be free banking. Although he did not already know everything he was to write (and thus there is still room to think that I had some input into this work—opportunities for such self-flattery are among the leading rewards of an academic career), I cannot claim that he “got the message” primarily from me. I cannot even claim that Selgin is building largely on my shoulders—one shoulder at most. The breadth and depth of his self-directed reading in monetary theory is evident throughout this work and is perhaps its most impressive aspect. From the outset we have been colleagues pursuing complementary lines of research rather than teacher and student. To see this work by my colleague in print is a pleasure indeed.
Lawrence H. White
[* ] John Hicks, “Monetary Theory and History—An Attempt at Perspective,” in Critical Essays in Monetary Theory (Oxford: Clarendon Press, 1967), pp. 156-57.
[* ] Robert J. Barro, “United States Inflation and the Choice of a Monetary Standard,” in Robert E. Hall, ed., Inflation: Causes and Effects (Chicago: University of Chicago Press for the National Bureau of Economic Research, 1982), p. 110 n. 2.
[† ] Lawrence H. White, Free Banking in Britain: Theory, Experience, and Debate, 1800-1845 (Cambridge: Cambridge University Press, 1984), ch. 1.
[* ] I have in mind such economists as F. A. Hayek, Roland Vaubel, Leland B. Yeager, Gerald P. O’Driscoll, Jr., Neil Wallace, myself, and Milton Friedman. All but Wallace are represented in chapters 13-18 of James A. Dorn and Anna J. Schwartz, eds., The Search for Stable Money (Chicago: University of Chicago Press, 1987).
[* ] Arjo Klamer, Conversations with Economists: New Classical Economists and Opponents Speak Out on the Current Controversy in Macroeconomics (Totowa, N.J.: Rowman & Allanheld, 1984), p. 78.